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Turning a Bad Year into Tax Savings

November 25, 2001

This tax year might be one of those times you just have to take your lemons and make lemonade. Investment losses--or worse, a reduced income due to a layoff or slashed bonus--are bound to leave a bitter taste. And this year's tax cut may wind up seeming like the too-small lollipop you got as a kid after a doctor's shot: Just a half-percentage-point drop in rates is slated for 2001. The cut itself will create problems for some, leaving more taxpayers susceptible to the dreaded Alternative Minimum Tax (AMT).

However, you can squeeze some benefits from your disappointments. And that tax cut will get better in coming years, with rates falling through 2006. Before it's over, the 28% bracket will drop to 25%; the top 39.6% rate will decline to 35%. There are goodies for education as well. One may let you write off thousands in tuition, beginning in 2002, depending on income.

RICH HARVEST. This may be an especially good year to postpone income (maybe asking your boss to give you that bonus--if you still have one--in January) and to accelerate deductions in order to reduce your taxable income. Income, of course, can be hard to move. And in an ailing economy, a payment delayed may be one never received.

One of this year's most obvious ploys to reduce your bottom line is to dump losing investments and use the capital losses to offset gains. Don't have capital gains? You still can write off up to $3,000 of your losses against ordinary income, carrying the rest forward until it's gone. If you don't think those Inktomi shares, say, are destined to bounce back soon, why not sell by yearend and harvest the loss? Just remember: You must first apply long-term losses against any long-term gains (typically taxed at the low 20% rate); then, short-term losses against short-term gains (taxed at your regular income-tax rate). After that, you're free to mix and match until all gains have been offset, then start applying the losses against ordinary income. Harold Shapiro, a CPA in Worcester, Mass., says one of his clients will be taking $100,000 in stock losses this year, even though he'll have to carry forward about 70% of it.

If you sell to claim losses, you can't repurchase the stocks or mutual funds within 30 days. Otherwise, the loss will be disallowed. For mutual funds, a way around this is to substitute a similar fund for the one you're selling.

When dealing with capital gains, you want to avoid triggering the AMT. This shadow tax system was designed to keep fat cats from using fancy deductions and special tax rates (like the low rate for long-term gains) to escape paying taxes. It kicks in when a taxpayer's bill falls below what it would be if calculated under the more stringent AMT rules. Unfortunately, as incomes and stock ownership have risen, more Americans are getting rerouted into this alternate system. The recently passed tax package, with its lower rates, will increase that threat as more and more taxpayers see their burden drop below what they would owe under the AMT, where the rates haven't changed, warns Don Weigandt, a wealth adviser at J.P. Morgan Private Bank.

Residents of high-tax states such as New York and California are especially vulnerable, since deductions for state taxes are disallowed under the AMT. Investors with lots of long-term capital gains or incentive stock options are also at risk: The AMT doesn't honor the special treatment given them under the regular tax system. David Rhine, a Rochelle Park (N.J.) financial planner, tells of a New York client who profited from the sale of a business this year. Normally, the man would prepay some state tax to increase his deduction and reduce the bite on this year's extra income. But he's afraid that using more of a deduction not honored by the AMT would simply push him into the alternate system.

That old rule--defer income and accelerate deductions--may not apply for those skating near the AMT. It might be better to postpone some deductions if you're near the line. The only way to know for sure is to estimate your regular tax, then run the numbers again using IRS Form 6251 for the AMT.

If you exercised incentive stock options (ISOs) this year, you especially need to check your AMT liability. With ISOs, the difference between the exercise price and the market price on the day you bought the stock is considered a profit under the AMT, even if you didn't sell. That could be a disaster if the stock is now trading much lower. To head off this problem, dump the stock before yearend. That changes the tax treatment of the options, leaving you owing ordinary tax only on any actual profit above your exercise price.

There are other ways to make the best of falling stock prices. If you have a traditional individual retirement account, consider converting to a Roth IRA, where withdrawals are tax-free after you retire. To do this, you first have to pay income taxes on the assets inside the traditional IRA. If your IRA held lots of stocks, it has probably dropped in value, and it'll cost you less in taxes to make the switch. "If your IRA was worth $100,000 last year and now it's only worth $80,000, you pay tax on 20% less money," says Ed Slott, publisher of Ed Slott's IRA Advisor. One caveat: Filers with modified adjusted gross incomes above $100,000 are ineligible to convert.

A BIGGER PUNCH. For similar reasons, the market's fall may be good news for those who want to take advantage of the new 18% capital-gains rate on assets held five years or longer. The clock started ticking on this rate on Jan. 1, 2001, but the rate applies only to assets purchased on or after that date. Those who bought earlier do have an out. They can take a "deemed sale and repurchase election." Here, you don't actually sell your investment in such things as stocks or real estate. Instead, you pay taxes as though you had, based on the closing price or value at the start of 2001. Five years down the road, those assets qualify for the 18% rate on any gains since. Be warned: This might not be a good strategy if it generates large gains you don't have capital losses to cover. And paying the taxes early will be really galling if the investment later tumbles.

However, prepaying some of next year's state and local taxes and mailing out the January mortgage payment in December are time-honored ways to accelerate deductions. For a bigger punch, goose your charitable deduction by contributing to a donor-advised fund. Working through a community trust or an investment firm such as Fidelity or Vanguard, you contribute a chunk of money or securities and get to write off the contribution this year. The money is then doled out over time to charities of your choice.

None of these tricks will make you feel as good as when stocks were booming and employers were wooing you with fat raises and free lattes. This year, you'll have to settle for lemonade.

Corrections and Clarifications

"Turning a bad year into tax savings" (BusinessWeek Investor, Nov. 26) incorrectly stated that long-term capital gains lose their special tax treatment under the alternative minimum tax. They are taxed at the same rate under both the AMT and the regular tax system.